Surety bonds are financial instruments that help minimize the risk of failure for companies and individuals involved in contractual agreements. They do this by requiring the third party to guarantee certain obligations can be fulfilled. If an agreement fails, the surety company steps in to cover the expense. Operating as an insurer, surety companies underwrite surety bonds to protect against the risk of loss. They assess various factors to determine if a potential client is likely to uphold their obligations. In doing so, they mitigate the risk of having to pay out on any claim. To understand what underwriting is and how it applies to surety bond underwriting, you need a quick primer on trust funds and financial statements.
What is a Surety Bond?
A surety bond is a contract where a third party (the “surety”) is legally obligated to pay the full amount of a claim if the principal (the “obligee”) fails to perform. The surety bond is issued to a third party that is usually involved in contractual agreements. In the case of government contracting, the surety bond is issued to a federal agency – like the General Services Administration (GSA) or the Department of Defense (DoD) – that is guaranteeing the completion of the project. A surety bond is different from a typical insurance policy because there is no risk of loss for the surety company. If there is a claim, the surety will step in and pay the full amount, with no out-of-pocket cost.
Trust Fund Conditions and Requirements
When a surety company underwrites a bond, it will typically set conditions on the usage of the funds. This is called a trust fund requirement. It is there to ensure that the funds are being used appropriately. Most surety companies require that the trust fund be kept in an account with a financial institution. It is often referred to as a “trust fund” account. The account is usually a commercial checking account or a money market account. Some surety companies may also require that the funds be deposited with a bonding company. This is usually done for larger bond amounts. If the funds are being used for payroll expenses, the surety company may require that the funds be kept in a federal reserve account. This is an account maintained by banks at the Federal Reserve. It provides a source of liquidity in the event of a run on the banks.
Financial Statements: Balance Sheet and Income Statement
Understanding how financial statements are used in underwriting surety bonds can help you understand the method behind the madness. The surety company will look at a client’s financial statements to see if their financials are strong enough to cover the costs of the bond. What financial statements? There are two types of documents that companies use to communicate their financial health to their shareholders, lenders, and investors: the balance sheet and the income statement. The balance sheet is a snapshot of the company’s financial health at a given moment. It shows how much the company has in assets, how much they owe in liabilities, and how much they are worth overall. The income statement shows how much money the company made over a given period of time. It helps investors, lenders, and others determine if the company is making money.
Risk Assessment: Leverage, Liquidity, and Operational Risk
When underwriting surety bonds, the surety company will assess operational risk, liquidity risk, and leverage risk. Let’s break down each of these to see how they factor into the underwriting process. Operational risk is the risk that the company will be unable to meet contractual obligations due to internal factors. Underwriting will look at the company’s past performance to gauge its likelihood of default. If you are a brand new company with no track record, the underwriter will be more conservative. On the other hand, if you have a stellar record as an established company, the underwriter will be more aggressive.
Other Assessments: Reputation, Auditing, and Collateral
The surety company will also look at reputation risk and auditing risk, as well as the existence of collateral. Reputation risk refers to the level of risk that a business will sustain reputational damage due to a claim. The surety company will look at the company’s reputation to determine if it is likely to be affected by a potential claim. Auditing risk refers to the likelihood that a financial statement will be audited by an outside party. If a company’s financial statements are likely to be audited, it is an indication of internal risk. Finally, if the business has collateral, this will lower the risk of the bond. Sureties are often required to post collateral when the company is unable to pay the face amount of the bond.
Summing up
Surety bonds protect parties who are entering a contractual agreement from the risk of non-performance. While risk is inherent in any transaction, a surety bond can help minimize it by providing a third-party guarantee. The surety underwriter assesses risk to determine whether to issue a surety bond. In doing so, they look at financial statements to determine if a company has the financial strength to cover the costs of a bond.